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2013-05-21 04:49:25
Investors think equities are the best bet in times of expansive monetary policy
May 18th 2013 |From the print edition
EQUITY bulls are on the charge. The Dow Jones Industrial Average and the S&P
500 index have each notched up record highs so far this year, with investors
enjoying double-digit gains. European shares, as measured by the Stoxx Europe
600 index, have reached their highest levels in almost five years.
So what is fuelling the rally? It does not seem to be the strength of the
global economy. Recent data have been mixed. Last month the IMF lowered its
global-growth forecast for the year from 3.5% to 3.3%. If global growth
prospects were improving, one would expect emerging-market stockmarkets to be
performing well, too; in fact, they have been flat this year (see chart). And
commodity prices usually strengthen when the economy improves, but The
Economist s all-items index has fallen by 3.2% so far this year, with
industrial materials dropping by 7.1%.
Nor is the rally due to a surge in profits. First-quarter results from firms in
the S&P 500 were better than expected, but they usually are (thanks to careful
management of expectations) and they still showed only a 5.1% increase in
profits compared with the same period of 2012. If financial companies are
excluded, the gain was just 2.6%. In Europe first-quarter earnings were 3%
lower than they were a year ago, or 7.3% if financial firms are left out,
according to Morgan Stanley, an investment bank.
Perhaps the most popular explanation relates to the commitment of the Bank of
Japan (BOJ) to eliminate deflation with the help of a big increase in the
monetary base. The bank s actions have encouraged hopes that Japan s economy
might emerge from its doldrums. Abenomics has already boosted growth.
Government data released on May 16th showed that GDP rose by 0.9% in the first
quarter, an annualised growth of 3.5%. The Tokyo market has been the best
performer among rich countries this year, in local-currency terms, with the
Topix 500 index up by 46% so far and by 68% over the past 12 months.
The actions of the BOJ are the latest example of an asset-buying programme by a
central bank. Such programmes push down bond yields and encourage investors to
buy risky assets. But Hans Lorenzen of Citigroup, another bank, says the
programmes also reduce the total supply of assets that private investors can
buy. He estimates that the natural growth in the outstanding volume of
financial securities has been reduced by several trillion dollars a year, which
has pushed prices higher.
The scale of the BOJ s programme may also have offset investors concerns that
the Federal Reserve could slow its quantitative easing (QE) purchases. Mr
Lorenzen calculates that the S&P 500 has risen by more than 70% cumulatively in
periods when the Fed was pursuing QE and fallen by around 15% when it has
paused. Investors may have taken heart, too, from monetary easing elsewhere:
many central banks have cut rates in recent weeks, including the euro zone s.
Slowing inflation, mainly thanks to weaker commodity prices, has made those
cuts possible. American inflation expectations in the bond market, as measured
by the gap between the yields on conventional and inflation-linked bonds, have
fallen from 2.64% last September to 2.33%. Cheaper commodities also act as a
tax cut for consumers in the rich world and can boost demand for other goods.
Judging by the latest retail-sales data, consumption has held up well in
America despite the recent fiscal tightening there.
Low inflation has reassured investors that central banks can keep their feet on
the monetary accelerator and enabled share prices to increase faster than
profits. But have prices risen too far? The valuation of stockmarkets can be
gauged in two ways: relative and absolute. In relative terms, the convention is
to compare the valuation of equities with that of government bonds or cash, and
calculate the risk premium (the higher return investors demand for putting
money into the more volatile stockmarket).
A new paper by Fernando Duarte and Carlo Rosa, two researchers at the New York
Fed, analyses 29 separate models used to calculate the expected premium over
the past 50 years. A weighted average of those models suggests that the current
premium is around 5.4 percentage points, about as high as it was after the bear
market of the mid-1970s and close to the recent share-price bottom in early
2009. That makes equities look like a bargain.
In contrast, the cyclically adjusted price-earnings ratio of the American
stockmarket, which averages profits over ten years, is currently 23.2, as
calculated by Robert Shiller of Yale University. That valuation is well above
the historical average, suggesting lower, not higher, equity returns from here.
Is it possible to square the absolute with the relative measures? Equities may
perform much better than government bonds, but only because those bonds will
provide dreadful returns. The New York Fed researchers found that the main
reason for the high risk premium was the exceptionally low level of yields. In
America, Britain, Germany and Japan, ten-year bond yields are all below 2%.
Another possibility is that profits can advance even further in America, they
are at their highest proportion of GDP since the second world war. There is
little sign that profits will be eroded by wage growth. And commodity-price
falls have relieved another cost pressure. But some of the strength of American
profits has come from overseas sales. In particular, a 17.8% fall in the
trade-weighted dollar between March 2009 and July 2011 boosted the value of
foreign profits. The dollar has since stabilised on a trade-weighted basis, and
with global trade expected to grow only slowly, the boost from foreign profits
may be dissipating.
Still, because of the unappealing nature of likely bond and cash returns, it
would probably take a shock to derail the equity rally in the near term. Such a
shock could be economic (a sudden surge in inflation that prompted a change in
monetary policy, say) or geopolitical (a wider war in the Middle East, for
example). But for now, the bulls see no need to worry.
From the print edition: Finance and economics